'Shareholder democracy' can mask abuses

Published 10:01 pm, Wednesday, February 27, 2013

Martin Lipton, one of the nation's top corporate lawyers, was dismayed.

Having watched David Einhorn, the activist investor, go to battle with Apple in the last two weeks to push it to distribute some of its $137 billion cash hoard to shareholders, Lipton had seen enough. Einhorn, he thought, had gone too far.

A longtime counselor to the Fortune 500 as one of the founding partners of Wachtell, Lipton, Rosen & Katz, he sat down and wrote a scathing memo to his clients on his view that "shareholder democracy" has run amok.

"The activist-hedge-fund attack on Apple -- in which one of the most successful, long-term-visionary companies of all time is being told by a money manager that Apple is doing things all wrong and should focus on short-term return of cash -- is a clarion call for effective action to deal with the misuse of shareholder power," he wrote. The memo was titled, "Bite the Apple; Poison the Apple; Paralyze the Company; Wreck the Economy."

Lipton said that long-term shareholders in public companies are being undermined "by a gaggle of activist hedge funds who troll through SEC filings looking for opportunities to demand a change in a company's strategy or portfolio that will create a short-term profit without regard to the impact on the company's long-term prospects."

While "shareholder democracy" may be a good sound bite, Lipton has a point worth considering.

It increasingly appears that the rise of "shareholder democracy" is leading, in some cases, to a perverse game in which so-called activist investors take to the news media to pump or dump stocks in hopes of creating a fleeting rise or fall in a company's stock price. The battle over Apple is just one minor example. Carl Icahn's investment in Herbalife, betting against William Ackman's accusation that the company is a "pyramid scheme," is another.

That's not to say that shareholder democracy is a bad thing. Shareholders have successfully and properly brought pressure to bear on underperforming companies, pushed out entrenched directors and, in some cases, pressed for operational changes to address health and the environment.

At a time when investors are calling for managements and directors to think more about the long term, this latest breed of activism is also multiplying. But are these activists interested in the long term?

According to Leo E. Strine Jr., the chief judge of the Delaware Court of Chancery, the answer is usually obvious: no.

"Many activist investors hold their stock for a very short period of time and may have the potential to reap profits based on short-term trading strategies that arbitrage corporate policies," he wrote in a widely circulated essay for the American Bar Association. Near the beginning of his essay he asked: "Why should we expect corporations to chart a sound long-term course of economic growth, if the so-called investors who determine the fate of their managers do not themselves act or think with the long term in mind?"

As for Einhorn's fight with Apple, it is hard to argue he is a short-term investor in the company; his firm, Greenlight Capital, has held a stake for the past three years. But the measures he is pressing the company to pursue -- creating a "iPref" or preferred share that pays a dividend to shareholders in perpetuity -- feel a lot like financial engineering to create some quick value for investors.

In his news release announcing his proposal, which would have Apple set aside $50 billion, he said that that amount of perpetual preferred stock "would unlock about $30 billion, or $32 per share in value. Greenlight believes that Apple has the capacity to ultimately distribute several hundred billion dollars of preferred, which would unlock hundreds of dollars of value per share." He continued, "Greenlight believes additional value may be realized when Apple's price-to-earnings multiple expands, as the market appreciates a more shareholder-friendly capital allocation policy."

In truth, Einhorn's proposal is a lot more long-term thinking than just pressing Apple to distribute a special one-time dividend or pursue a series of stock buybacks; his proposal requires shareholders to remain so as to reap the dividends the special "iPrefs" would throw off. But make no mistake, Einhorn is also hoping that Apple's common shares will jump in price if Apple takes up his proposal.